Earn Dividends From Convertible Bonds

Convertible bonds could be the perfect investment for these fragile economic times. Because they're bonds that may be turned into shares of the issuer, you can benefit if the stock market takes off. But if the market falters, your bond could maintain its value and at the same time produce a generous stream of income.

The recent performance of convertibles bears out their benefits. Over the past year through February 11, the Bank of America Merrill Lynch All U.S. Convertibles index returned 23.9% -- just two percentage points less than Standard & Poor's 500-stock index. "Investors are looking for safety," says George Graham, editor of the Value Line Convertibles Survey newsletter.

Don't expect convertibles to keep pace with stocks in the future; their returns usually fall between those of stocks and bonds, as you might expect from such hybrids. But they should boost the return and dampen the volatility of your overall bond portfolio. A study by brokerage Raymond James showed that over a 15-year period, devoting just 15% of a bond portfolio to converts (a prudent percentage) increased annual returns by an average of three-fourths of a percentage point and reduced volatility by 10%.

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Because converts (which come as both convertible preferred stocks and convertible bonds) are tricky, and because most issuers have middling to crummy credit ratings, most investors are better off investing through a fund. Our favorite is Vanguard Convertible Securities (symbol VCVSX). The fund earned 7.2% annualized over the past ten years through February 11 -- tops in its category -- and currently yields 2.9%.

Co-manager Larry Keele likes to play defense, and it shows in his fund's performance during tough times. Vanguard lost 30% during the 2008 disaster, compared with a loss of 33% for the average convertible fund. "A lot of my performance advantage has come from outperforming in the down markets," says Keele. To that end, he first checks on a bond's price to make sure he's getting a good deal, then he assesses a company's creditworthiness. "We won't invest if we're suspicious about stability," he says.

Another advantage of the Vanguard fund is that it may have significant exposure to overseas converts; its recently amended charter allows it to place up to 30% of assets in such securities. Over the past ten years, foreign converts returned an average of two percentage points per year more than U.S. converts.

If you want convertibles with a bit more horsepower, hitch a ride with Fidelity Convertible Securities (FCVSX). Since 2006, shortly after Tom Soviero became manager, Fidelity has beaten Vanguard four years out of five. But the one year it lagged was a doozy: Fidelity lost 48% in 2008 (then rebounded with a stunning 64% gain in 2009). The Fidelity fund yields 3.0%.

How a Convertible Works

A convertible bond can be turned into a set number of the issuer's shares. It pays less interest than a regular bond, but the conversion feature can be valuable. For example: With the stock at, say, $15, you buy a $1,000 bond that pays 4% interest and can be converted into 50 shares of the issuer's stock. It doesn't pay to convert with the stock at $15 because your shares would be worth only $750. Below are some potential outcomes.

Lousy: The bond's issuer falls on hard times, its stock craters, and it defaults on its loans -- including your bond, which plummets in value.

Okay: The stock's price stays put or moves just a bit. You collect your 4% annual interest, and when the bond matures, you get back your $1,000.

Awesome: The stock's price doubles, to $30. If you were to convert, you'd own $1,500 worth of the stock, so the value of your bond rises to $1,500.